The difference between a tax credit and a tax deduction

Here’s the difference in a nutshell between a tax credit and a tax deduction. Both are good things, but a tax credit is usually better than a tax deduction. Here’s an example to illustrate:

Let’s say that your taxable income is $50,000, and that your tax rate is 25%. (I’m purposely leaving out exemptions, and other things to simplify the illustration).

So, normally, your tax would be $12,500 because 25% of $50,000 is $12,500. That leaves you with an after tax income of $37,500.

Now, let’s say that you have a tax deduction of $2,000. That means that your taxable income is reduced by $2,000. So, instead of taking 25% of $50,000, we’ll take 25% of only $48,000. So, that means that your tax is now $12,000 (25% of $48,000), and your after tax income is $38,000 ($50,000 – $12,000). So, you get to keep $500 more with the deduction. Great. Keep in mind that sometimes tax deductions can lower your tax bracket…so they can help in that way too.

Now, let’s say that you have a tax credit of $2,000. You’ll see why this one is better in just a bit :). A tax credit is a dollar for dollar reduction in the tax that you pay. So, your taxable income is still $50,000, and we’re still going to take 25% of $50,000, which is still $12,500. But, now, we’re going to reduce the amount of tax by $2,000, so now your tax is only $10,500 ($12,500 – $2,000). So, now your after tax income is $39,500 ($50,000 – 10,500). You now have $2,000 more than when there wasn’t any credit or deduction, and you have $1,500 more than when you only had a deduction. Whoo-hoo! Don’t spend it all in one place!!